Pros and Cons of Different Types of Small Business Loans
There are a variety of different types of loan options for small businesses seeking a cash influsion to support operations or promote growth. Each loan option offer benefits and drawbacks. Understanding the pros and cons to different types of small business loans is essential to maximizing return on investment and limiting the down side risk associated with using debt financing.
Pros and Cons by Loan Type
The following chart provides a summary of the pros and cons of the most popular types small business loans. For a more detailed list of the pros and cons for a specific loan, click the row title in the first column.
|Equipment Financing||Equipment financing is easier acquire than a business bank loan and is collateralized by the equipment purchased.||Proceeds can only be used for the purchase of equipment and this form of financing often has a high interest rate.|
|Credit Cards||Provide quick access to funds that can be used for financing startup costs without collateral requirements.||May require a personal guarantee and higher interest rate. Borrowed funds must be repaid if the business fails.|
|SBA 7(a) Loans||Lower qualification requirements, lower interest rate, and lienent down payment requirements for small businesses.||Loan terms are determined by lenders, personal collateral may be required and the application process can be strenuous.|
|SBA 504 Loans||Easy qualification requirements, up to 90% of loan value, fixed financing and long-term amortization of payments.||Strenous application and underwriting process. Often takes from 60 to 75 days before funding is released.|
|SBA Microloans||Loan proceeds are usually distributed quickly and can be applied to a large variety of business and start-up costs.||Microloans have some spending restrictions and can take several weeks to be approved. Not all applicants qualify.|
|Microlenders||Typically offer low interest rates and require little to no collateral. Application and funding is relatively quick.||Have a relatively short repayment term compared to other loans. These loans typically come with spending restrictions.|
|Collateralized Loan||Usually offer lower interest rates, longer repayment terms and higher loan amounts than unsecured financing.||Requires an acceptable security asset that will be seized in the event of loan default. Only established businesses qualify.|
|Accounts Receivable Loan||Provides fast funding with minimal credit requirements. Collection of receivables can be outsourced to a 3rd party.||Is typically more costly than other forms of financing. Financing terms are based on customers' credit worthiness.|
Equipment financing loans are designed to assist with the purchase of business equipment. They’re ideal for small businesses who rely on expensive equipment to support ongoing business operations.
- 1. Access to funds for purchasing equipment. Equipment financing loans provide much needed cash for large equipment purchases. This is an ideal loan for businesses that depend on equipment to support operations.
- 2. Frees up cash flow. Equipment purchases can drain a small business dry. Equipment financing loans help solve cash flow issues presented by larger equipment purchases.
- 3. No collateral requirement. Traditional loans may require personal collateral, such as real estate or vehicles. With an equipment financing loan the equipment serves as the collateral. No personal collateral is required, whereby lowering downside risk for the business.
- 1. Proceeds must be used for equipment. Equipment financing loans can only be used for the purchase of equipment. Funds cannot be used to cover rent, payroll, or any other business expenses.
- 2. Relatively high interest rates. Compared to traditional loans, equipment financing loans have high interest rates. For businesses with an established credit history, a traditional bank loan will be less expensive than an equipment financing loan.
- 3. Equipment ownership. Owning equipment is sometimes a pro and sometimes a con. For equipment that depreciates quickly—or may become obsolete—the cost of ownership may be high. Equipment leasing is an alternative to equipment financing.
Credit cards provide quick access to cash for startups and small businesses that lack the credit history required to qualify for a traditional loan. There are several perks to financing business costs with credit cards, as well as a few drawbacks.
- 1. Easy access to funds. If you already have personal credit card, qualifying for a business credit card isn’t usually hard—especially if your business has a good credit history. Business credit cards allow you to with draw the funds you need when you need them for whatever you need them.
- 2. Revolving credit line. Having a revolving credit line allows you to borrow money up to the limit of your card and repay it as you’re able. Every time you pay down your credit balance, you free up credit to use for future purchases.
- 3. Maintain business ownership. Unlike other forms of financing, credit cards allow a business owner to maintain full business ownership. This is helpful for maintaining control of operations and seeking investors down the road.
- 4. No collateral requirement. Applying for a credit card does not require any type of collateral other than good credit history and a personal guarantee.
- 5. Attractive interest rates. As long as monthly minimum payments are made, credit cards can offer competitive interest rates. Many credit cards also provide 0% financing for up to 6 months as long as the balance is paid off. This is like an interest free loan for 6 months.
- 6. Tracking expenses. Using a business credit card to make purchases and cover costs is a great way to keep a detailed, easily accessible online log of expenses.
- 7. Rewards programs. Some credit cards offer attractive rewards programs that are redeemable for cash or travel. Rewards programs are an excellent way to cover additional business costs such as travel and lodging.
- 1. Secured by a personal guarantee. Credit card lenders require a personal guarantee—even for business lines of credit. The business owner becomes personally liable for misuse of the credit card, late payments and non-payment.
- 2. Sole liablity. The business owner is solely responsible for ensuring that credit card payments are made on time and balances are paid. If the business fails, the business owner is solely liable for any unpaid balance.
- 3. High Rates and Fees. Some business cards offer attractive rates, but many don’t. A business credit card typically has higher fees and interest rates than personal credit cards. Business credit cards can also have higher rates than traditional loans if minimum monthly payments are made timely.
- 4. Use and Abuse. Business credit cards have a tendency of being misused. If a business employee uses a business credit card liberally or for unauthorized expenses, the business owner is responsible. Business credit card usage should be closely monitored.
SBA 7(a) Loans
The SBA 7(a) loan is designed for small business owners who may not be able to secure other types of affordable business financing. Since the SBA is a non-profit organization, it doesn’t have the same high rates or fee structure as traditional for-profit lending institutions.
- 1. SBA 7(a) is easier to secure than a traditional bank loan. Since the federal government guarantees 75 to 85% of the SBA 7(a) loan, there is less risk to SBA lenders to make these loans to small business owners. Hence, lenders with approve SBA 7(a) loan applications they would ordinarily have rejected.
- 2. Lower interest rates and fees. Maximum interest rates for SBA 7(a) loans are set by the SBA. This makes SBA 7(a) loans more affordable to small business owners. SBA 7(a) interest rates typically range between 7 and 9 percent. (Note: Even lower interest rates may be available for qualifying businesses through a traditional loan program.)
- 3. Low down payent requirements. Traditional loans may require as much as a 20 percent down payment to ensure borrowers have substantial skin in the game and motivation to repay the loan. Many SBA 7(a) lenders will accept down payments of just 10 percent.
- 1. Loan terms may vary. SBA approved lenders may set loan terms at their discretion. SBA lenders have the ability to change approval and underwriting requirements as well as restructure the terms of the loan itself. Some lenders may even increase the initial down payment requirement and charge higher fees than they would for traditional loans.
- 2. Require collateral. The SBA often requires borrowers provide collateral, such as a house or real estate, for a SBA 7(a) loan. It is not an uncommon practice for the SBA to put on lien on personal or business property until a loan is repaid. In the event of default, the SBA may seize the asset collateral.
- 3. Strenous application process. Qualifying for an SBA 7(a) takes time, effort and a good credit history. Even though SBA loans are gauranteed by the government, they’re underwritten and issued directly from a private lender. Consequently, applicants are require to go through the lender’s application process. The approval process for an SBA 7(a) loan averages 45 days.
SBA 504 Loans
The SBA 504 is designed for small business owners who are purchasing equipment or commercial real estate to support business operations. SBA 504 loan amounts max out at $5.5 million. Repayment terms are 10, 20 or 25 years. The SBA 504 loan program offers business owners several advantages over other financing options. However, there are a few drawbacks borrowers should be aware of prior to applying.
- 1. Provide large amounts of financing. The SBA 504 program is ideal for business owners who need to borrow a substantial sum to cover the acquisition of equipment or real estate. Borrowers have access to 90% project financing. Traditional loans typically only cover 60-75% of project funding.
- 2. Longer-term ammortization. SBA 504 loans are amortized over 10, 20 or 25 years. This allows borrowers to spread the cost of the loan over a longer period of time whereby reducing the amount of monthly repayment obligations.
- 3. Fixed interest rates. Having a fixed interest rate is a major benefit of the SBA 504 loan. Borrowers are able to make a fixed payment for a fixed period of time, making it much easier to budget and manage monthly cashflow. In many ways, the 504 loan resembles a traditional fixed-rate home mortgage.
- 4. Lower fees. A traditional loan typically requires the borrower to pay up to 1% of the loan amount in closing fees. Even the SBA 7(a) has fees of 2%-3.75% of the total loan value. Loans fees for the 504 are capped at 2.65% of the loan’s value, but all fees are added to the loan amount and finances. With the SBA 504 loan, the borrower only has to come up with the down payment amount.
- 5. Relatively low down payment. The SBA 7(a) loan has down payment requirements between 10 and 15% of the total value of the loan. Conventional loans require borrowers to come up with 25 to 40% of the loan amount. Down payment requirements for the SBA 504 average about 10% of the loan value, making the 504 the most affordable option. (Note: down payment requirements will vary depending on the situation of the borrower.)
- 1. Restrictions on usage of funds. Proceeds from the SBA 504 must be used for specified puchases including land improvements, existing buildings, new equipment, new facilities or paying off debt from these purchases. Unlike the SBA 7(a) loan, proceeds from the 504 cannot be applied to working capital.
- 2. Extensive application process. There are three parties involved in the SBA 504 loan application process. Where a conventional loan application includes just the lender and the borrower, the 504 also includes a Certified Development Company (CDC). Both the lender and the CDC must agree on loan terms, while making sure all SBA requirements met. It may take 60 to 75 days for an SBA 504 to close and funding to be released.
- 3. Large down payment. While SBA 504s typically cover 90% of total project value, the borrower must still come up with a 10% down payment. While this percentage is relatively low compared to the SBA 7(a) or a conventional loan, given the larger size of most 504 projects, the down payment may still be relatively large. A 10% down payment on a $5.5 million SBA project ($550,000) is substantially greater than a 30% down payment on a $1.1 million conventional loan ($330,000).
- 4. Proceeds must support job creation. For every $65,000 received by the borrower, the small business must create or retain one job. If for any reason this requirement can’t be met by the borrower, an approved community development goal must be met by the borrower’s business.
SBA microloans are small business loans ranging from $1,000 to $50,000. The average microloan is just over $13,500. Proceeds from a microloan can be used for a variety of business purposes. Microloans are extended based on need, merit and the borrower’s ability to repay the loan.
- 1. Quick access to cash. The application process for most SBA loans is 45 to 75 days. The SBA microloan can close and fund in 30 days. In some cases, an SBA microloan may fund even faster.
- 2. Easy qualification. SBA Microloans are designed and intended for businesses that can’t qualify for a traditional bank or SBA loan. This includes both struggling startups and established businesses. Since these loans are relatively high risk, the SBA guarantees a portion of the loan to lower the risk to microloan lenders.
- 3. Low restrictions on use of funds. Microloans can be used to cover a wide range of business expenses. They can be used to pay for inventory and supplies. They can also be used for working capital and to purchase business equipment.
- 1. Restrictions on spending. The proceeds from SBA microloans can be used to cover a wide range for business expenses, but they can’t be used to pay off existing business debt or to purchase real estate. In this scenario, an SBA 7(a) or 504 loan is more advantageous than an SBA microloan.
- 2. Qualification requirements vary by vendor. Qualifying for an SBA microloan will vary from vendor to vendor. Some microloan lenders will scrutinize a business’s financial statements where others will not. While the SBA sets loan guidelines, individual SBA lenders have sole discretion to approve or deny loan applications.
- 3. Not all borrowers will be eligible. The SBA makes it easier for a small business to qualify for a microloan, but there are still several restrictions. Small businesses that have filed bankcrupty within the last two years or are non-profit do not qualify for an SBA microloan. Additionally, a low credit score may preclude a business from qualifying for an SBA microloan.
In addition to the SBA Microloan program, there are several private lenders and organizations that extend microloans to startups and small businesses. Unlike traditional lenders, microlenders are often individuals, nonprofit organizations and alternative lenders. Many microloans are now made through peer-to-peer (P2P) lending networks and platforms where many individuals invest small amounts of capital to fund just one microloan. There are pros and cons to using microlenders for small business financing.
- 1. Less stringent qualification requirements. Qualification criteria for a microloan is typically less stringent than it is for a conventional loan. Notwithstanding, microlenders still require personal and business financials, a personal guarantee, and collateral.
- 2. No restriction on fund usage. As with a traditional business loan, the funds from a microloan can typically be used for most business expenses such as materials, supplies, inventory, equipment and working capital. However, restrictions on use of funds may vary by lender, so review all terms and conditions prior to applying.
- 3. Diverse selection of lenders. Microloans are offered by a variety of lenders, including banks, credit unions, nonprofits, government agencies, P2P lending platforms as well as alternative lenders.
- 1. Low loan limits. An SBA microloan has an upper limit of $50,000, but a microloan of this amount is rare. In 2021, the average SBA microloan was $16,557. (source: CRS Report: Small Business Administration Microloan Program.) Most private microlenders extend microloans for even smaller amounts than the SBA. For microloans in excess of $20,000, small businesses with good credit may not quality.
- 2. Higher interest rates. When a borrower has bad credit, the interest rate charged on a micrloan may be high. As reported on Investopedia.com, the best-rated borrowers on microlending platform Prosper.com are charged a minimum 6% annual interest, while borrowers with the worst credit can expect to pay as much as 31.9%.
- 3. Lack of Availability Microlending is still not considered a mainstream form of lending for business financing. While microlending is popular in some parts of the nation, in others it’s rare. Over the last decade more lenders have setup on online microlending platforms to make microlending more accessible.
Collateratlized loans, also referred to as secured personal loans, require collateral to secure the loan. Where eligibility for an unsecured loan is based on the personal credit score or history of the borrower, secured loans are based on the value of the collaterlized asset.
- 1. Easy qualification. Personal credit worthiness is typically less of an issue with collateralized loans—since the asset secures the loan and lowers the lender’s risk. Lending guidelines for secured loans are not as stringent as they are for unsecured loans.
- 2. Lower interest rates. Because collateralized loans are lower risk to lenders, these loans are offered with a lower interest rate to borrowers. Where a typical credit card carries an interest rate of 20%, the interest rate for a secured loan is nearly half that.
- 3. Higher loan amount. Loan amount is typically based on the value of collateral. The higher the value of collateral, the more lenders are willing to loan. Providing lenders with collateral ensures the loan will be repaid in the event of default so lenders are willing to loan more.
- 4. Loan availability. Many types of lenders—including banks, credit unions, and alternative lenders—offer secured loans. This provides business owners the ability to shop the market to compare rates, fees, and repayment terms to find the best deal.
- 5. Build personal and business credit. Collateralized loans are an excellent way to build credit a business has little to no credit history. Once a business builds a strong credit profile, it may qualify for an unsecured personal loan in the future. If you intend to build your credit by securing a collateralized loan, make sure your lender reports loan payments to all major consumer credit bureaus.
- 1. Loss of collateral. The biggest drawback of secured loans is the potential for loss of the collateralized asset. If repayment of the loan is not made on time, the asset could be sold by the lender.
- 2. Limited loan amount. Since unsecured loans are tied directly to the value of the asset being collateralized, the loan amount is also limited to the value of the asset. If you need to borrow $50,000 but only have $30,000 in collateralized assets, you may not have enough collateral to quality for the needed funds.
- 3. Complex application process. Before an asset can be used as collateral, it must be appraised. The asset appraisal and application process for a collateralized loan requires that financial statements, tax returns and other information be collected, organized, submitted and reviewed. How long the application process for a collateralized loan takes will vary by lender, but it’s usually much more involved and lengthy than the application process for an unsecured loan.
Accounts Receivable Loan
An accounts receivable loan—also known as accounts receivable financing or invoice financing—allows a business to use it’s accounts receivables as collateral for a loan. Accounts receivables appear on the balance sheet as a current asset that can readily be turned into cash.
- 1. Fast access to funds. Accounts receivable financing is one of the quickest ways to access cash to cover business expenses. Some lenders will fund an accounts receivable loan within 24 hours. Hence, these loans are often used to cover short-term cash flow problems.
- 2. No or low personal credit requirements. With accounts receivable financing, what lenders are interested in is the quality of a company’s invoices. They’re more interested in customers’ credit score than they are yours, or that of your business. Since a company’s invoices serve as the loan collateral, lenders want to make sure customers are like to pay the invoices.
- 3. Retain ownership of the business. An accounts receivable loan allows a business owner to maintain ownership of his or her business—and business assets. Only the accounts receivable serve as loan collateral. The only recourse a lender has in case of default is collection of outstanding accounts receivable (as well a increased fees to the borrower.)
- 1. Are typically costly. An accounts receivable loan can provide quick cash, but it often comes at a higher price than other forms of business financing. Interest rates and feeds for accounts receivable loans depend on the industry, creditworthiness of customers, customer payment history, quality of invoices, and average invoice amount. When the borrower fails to pay back the loan amount within the agreed upon timeframe, the total required payback amount to the lender may increase.
- 2. Dependency on customers. Where most loans are based on personal creditworthiness, accounts receivable loans are based on the credit score and history of a business’s customers. If a business’s customers have poor credit history, or a habit not paying their bills on time, a business may have difficulty qualifying for an accounts receivable loan that makes financial sense.
Conclusion: Considering Small Business Loan Alternatives
Financing a small business through debt is often the best way to gain access to funds needed to support operations and promote growth. However, each form of debt comes with pros and cons. If debt financing is an essential financing strategy for a small business, it’s important that a business weigh the pros and cons of each financing options based on it’s merits as well as the associated risk. Remember, debt creates an obligation to a creditor that must be repaid.
I recommend never taking on a debt load that comes with unreasonable terms or could potentially jeopardize the long-term viability of a small business in the case of default.